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Find out how to pairs trade using CFDs

By: Ic Markets

Read More About Currency Trading

Pairs trading is the action of a trader going long one CFD and simultaneously going short another. As the trader has bought one CFD and short the other they are not affected by broader market price movements instead they are subject to the price movements of the pair of stocks which they are trading. As long as the investor buys the outperforming security or sells the under performing security they will make money.

Most traders buy Contracts for difference with the expectation that the market will rise, few traders take sold positions with the opinion the market will fall. Pairs traders do not care about market trend and don’t mind which way the market moves so long as they select a strong pair of associated stocks.

Pairs trading has become widespread since the introduction of CFDs, prior to this it was not easy for a investor to short sell. CFDs have made pairs trading easy and accessible to the everyday investor.

Most traders adopt pairs trading strategies when there is uncertainty as to the trend of the market. The rationale for this is that it eliminates market risk, whether the trade generates profits will depend on whether the trader buys a CFD that will outperform or sells a Contract for difference that will under perform. A typical example of this would be buying Commonwealth Bank (CBA) and selling ANZ Bank (ANZ), because the trader expects that CBA will outperform ANZ. If both stocks rise or fall the trader is going to be indifferent, however should CBA rise and ANZ fall as the trader anticipated, the trader will make money. If CBA falls less than ANZ the trader will make money likewise if CBA rises more than ANZ the trader will also generate profits.

There are a number of benefits of using Contracts for difference in your pairs trading strategy. One of the main benefits is the financing offset that is going to be achieved when the trader earns a financing revenue on their short position. Take the above illustration for instance, when the trader opens the long CFD position on CBA they will pay a small financing charge however when the trader sells the ANZ Contract for difference they will receive financing revenue. Although the offset is not 100% it will without doubt decrease the cost of the trade. In many ways pairs trading as a short to medium term strategy and can be less costly and less dangerous than simply opening a naked long or short position.

Pairs trading is not only frequently used when trading share Contracts for difference it has also become extraordinarily common for use with indices. When using Contracts for difference over indices traders can take the view that one index will outperform the other. An example of this may be the US market versus the Australian market. In this illustration you would buy the ASX 200 index Contract for difference and sell the S&P 500 index Contract for difference with the opinion that the Australian market will outperform the US market.

Pairs traders adopt a number of strategies, one of the more typical strategies used is to pick pairs that are correlated, for example Stockland against Mirvac or Rio Tinto against BHP Billiton. It is also common for traders to use sector CFDs in their strategy such as the health care sector versus the materials sector or energy sector versus the ASX 200 index.

An illustration of sector trading would be the resources sector versus the ASX 200 index. The trader might be of the view that the resources sector is overvalued compared to to the market and will under perform the market, the trader would short the resources sector and buy the ASX 200 index. Alternatively the trader may feel that the market will pull back and money will move back into the defensive shares, in this case the trader would buy the health care sector and sell the energy sector. When choosing sectors the trader should consider their weighting within the whole index as this will help the trader establish the sectors correlation to the overall market. Pairs trading can be done on almost any financial instrument except currencies which by their very nature are allready a pairs trade.

Article Source: http://depositarticles.com/

Vist IC Markets website to get your free CFD ebook and find out more about pairs trading CFDs.

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